A futures contract is an agreement between two parties. The buyer pays the seller today for the promise of the commodity at a future date. Futures contracts are traded in futures exchanges. The commodities can be things such as livestock, agriculture produce, metals, energy, and financial products. Trading futures can be profitable. But it is also complex and very risky. Instead of gaining a profit, an investor can lose the money invested. They could be required to pay more than they invested.
Margin is the amount of money investors must give to the exchange, in order for contracts to be ensured against counterparty risk. Initial margin ranges around 10% of the total value of the contract. Margin rates can be lowered for hedgers since the contracts are covered by assets.
- Buffett is a farmer. He expects to harvest a hundredweight of corn. He wants a guaranteed price after the harvest is finished. Buffett would short a futures contract. He is obligated to deliver the corn at expiration.
- Graham works for ABC Airlines. The company's performance is very sensitive to fuel prices, so ABC Airlines needs guaranteed fuel prices. Graham would buy a futures contract, and the airline would receive fuel at expiration, at the price set.
- Hwang is a speculator. He believes that Treasury bond prices will go down. He shorts 10-year bond futures, and cancels his contract before expiration. If Hwang had incurred a large loss, his broker, or investment bank may have issued a margin call.
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